Accounting, Fourth Edition

Accounting, Fourth Edition
13 FINANCIAL ANALYSIS: THE BIG PICTURE Accounting, Fourth Edition

Study Objectives Understand the concept of sustainable income.
Indicate how irregular items are presented. Explain the concept of comprehensive income. Describe and apply horizontal analysis. Describe and apply vertical analysis. Identify and compute ratios used in analyzing a company’s liquidity, solvency, and profitability. Understand the concept of quality of earnings.

Financial Analysis: The Big Picture
Sustainable Income Comparative Analysis Ratio Analysis Quality of Earnings Irregular items Changes in accounting principles Comprehensive income Horizontal analysis Vertical analysis Liquidity ratios Solvency ratios Profitability ratios Alternative accounting methods Pro forma income Improper recognition Price-earnings ratio

Sustainable Income Sustainable Income - Net income adjusted for irregular items. Irregular items are separately identified on the income statement. Two types are: Discontinued operations. Extraordinary items. These “irregular” items are reported net of income taxes. SO 1 Understand the concept of sustainable income. SO 2 Indicate how irregular items are presented.

Sustainable Income Components of the income statement
Illustration 13-1 Components of the income statement SO 2 Indicate how irregular items are presented.

Sustainable Income Discontinued Operations
Disposal of a significant component of a business. Income statement should report a gain (or loss) from discontinued operations, net of tax. SO 2 Indicate how irregular items are presented.

Sustainable Income Illustration: Rozek Inc. has revenues of $2.5 million and expenses of $1.7 million from continuing operations in The company therefore has income before income taxes of $800,000. During 2012 the company discontinued and sold its unprofitable chemical division at a loss of $210,000 (net of $90,000 tax savings). Illustration 13-2 SO 2

Sustainable Income Extraordinary items are events and transactions that meet two conditions: Both Unusual in nature and Infrequent in occurrence Company must consider the environment in which it operates. Amounts reported “net of tax.” SO 2 Indicate how irregular items are presented.

Sustainable Income Illustration: In 2012 a revolutionary foreign government expropriated property held as an investment by Rozek Inc. If the loss is $70,000 before applicable income tax savings of $21,000, how will the loss be presented in the income statement? Illustration 13-3 SO 2 Indicate how irregular items are presented.

Sustainable Income Are these considered Extraordinary Items? YES NO NO
Effects of major natural casualties, if rare in the area. Effects of major natural casualties, not uncommon in the area. Write-down of inventories or write-off of receivables. Expropriation (takeover) of property by a foreign government. YES NO NO YES SO 2 Indicate how irregular items are presented.

Sustainable Income Are these considered Extraordinary Items? NO YES NO
Losses attributable to labor strikes. Effects of a newly enacted law or regulation, such as a condemnation action. Gains or losses from sales of property, plant, or equipment. NO YES NO SO 2 Indicate how irregular items are presented.

Sustainable Income Changes in Accounting Principle
Principle used in the current year is different from one used in the preceding year. Example - change from FIFO to average cost. Permissible when management can show new principle is preferable. Most changes are reported retroactively. SO 2 Indicate how irregular items are presented.

Sustainable Income Comprehensive Income
All changes in stockholders’ equity except those resulting from investments by stockholders and distributions to stockholders. Certain gains and losses bypass net income and instead are reported as direct adjustments to stockholders’ equity. Example – Unrealized gain or loss on Available-for-sale securities SO 3 Explain the concept of comprehensive income.

Sustainable Income Illustration of Comprehensive Income
Accounting standards require companies to adjust most investments in stocks and bonds up or down to their market value at the end of each accounting period. Illustration: During 2012 Stassi Company purchased IBM stock for $10,000 as an investment. At the end of 2012 Stassi was still holding the investment, but the stock’s market value was now $8,000. How should Stassi account for the $2,000 unrealized loss? SO 3 Explain the concept of comprehensive income.

(Comprehensive Income - Stockholders’ Equity)
Sustainable Income Illustration of Comprehensive Income How should Stassi account for the $2,000 unrealized loss? Answer: Depends on whether Stassi classifies the IBM stock as a Trading security or an Available for-sale security. Unrealized gains and losses (Income Statement) Unrealized gains and losses (Comprehensive Income - Stockholders’ Equity) SO 3 Explain the concept of comprehensive income.

Sustainable Income Format One – Comprehensive Income
Combined statement of income and comprehensive income. Illustration 13-5 SO 3 Explain the concept of comprehensive income.

Sustainable Income Format Two - Comprehensive Income
Separate component of Stockholders’ Equity. Illustration 13-6 SO 3 Explain the concept of comprehensive income.

Sustainable Income Format Three - Comprehensive Income
Illustration 13-7 Complete Income Statement SO 3 Explain the concept of comprehensive income.

Income Statement (partial)
Sustainable Income Illustration: In its draft 2012 income statement, AIR Corporation reports income before income taxes $400,000, extraordinary loss due to earthquake $100,000, income taxes $120,000 (not including irregular items), and loss on disposal of discontinued flower division $140,000. The income tax rate is 30%. Prepare a correct income statement, beginning with income before income taxes. AIR CORPORATION Income Statement (partial) Income before income taxes $400,000 Income tax expense 120,000 Income before irregular items 280,000 Discontinued operations Loss on disposal of discontinued flower division, net of $42,000 tax savings (98,000) Extraordinary earthquake loss, net of $30,000 tax savings (70,000) Net income $112,000

Comparative Analysis Analyzing financial statements involves:
Comparison Bases Basic Tools Intracompany Intercompany Industry averages Horizontal analysis Vertical analysis Ratio Analysis

Comparative Analysis Horizontal Analysis
Also called trend analysis, is a technique for evaluating a series of financial statement data over a period of time. Purpose - to determine increase or decrease that has taken place. Commonly applied to the balance sheet and income statement. SO 4 Describe and apply horizontal analysis.

changes and percentage changes.
Comparative Analysis Illustration 13-11 Horizontal analysis of balance sheets Helpful Hint: When using horizontal analysis, be sure to examine both dollar amount changes and percentage changes. SO 4 Describe and apply horizontal analysis.

Comparative Analysis Illustration 13-12 Horizontal analysis of Income statements Helpful Hint: In horizontal analysis, while the amount column is additive (the total is $99 million), the percentage column is not additive (9.9% is not a total). SO 4 Describe and apply horizontal analysis.

Comparative Analysis Solution
Illustration: Summary financial information for Rosepatch Company is as follows. Compute the amount and percentage changes in 2012 using horizontal analysis, assuming 2011 is the base year. Solution SO 4 Describe and apply horizontal analysis.

Comparative Analysis Vertical Analysis
Also called common-size analysis, is a technique that expresses each financial statement item as a percent of a base amount. Vertical analysis is commonly applied to the balance sheet and the income statement. SO 5 Describe and apply vertical analysis.

These results indicate the company shifted
Comparative Analysis Illustration 13-13 Vertical analysis of Income statements These results indicate the company shifted toward equity financing by relying less on debt and by increasing the amount of retained earnings. SO 5 Describe and apply vertical analysis.

Comparative Analysis Illustration 13-14 Vertical analysis of an income statements The increase in net income as a percentage of sales is due primarily to the decrease in interest expense and income tax expense as a percent of sales. SO 5 Describe and apply vertical analysis.

Comparative Analysis Illustration 13-15 Intercompany comparison by vertical analysis Vertical analysis also enables a comparison of companies of different sizes. Although Chicago Cereal’s net sales are less than those of General Mills, vertical analysis eliminates the impact of this size difference for our analysis. SO 5 Describe and apply vertical analysis.

Financial Ratio Classifications
Ratio Analysis Ratio analysis expresses the relationship among selected items of financial statement data. Financial Ratio Classifications Liquidity Solvency Profitability Measures short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash. Measures the ability of the company to survive over a long period of time. Measures the income or operating success of a company for a given period of time. SO 6 Identify and compute ratios used in analyzing a company’s liquidity, solvency, and profitability.

Ratio Analysis Liquidity Ratios
Illustration 13-16 SO 6 Identify and compute ratios used in analyzing a company’s liquidity, solvency, and profitability.

Ratio Analysis Solvency Ratios

Ratio Analysis Profitability Ratios

Quality of Earnings A company that has a high quality of earnings provides full and transparent information that will not confuse or mislead users of the financial statements. Recent accounting scandals suggest that some companies are spending too much time managing their income and not enough time managing their business. SO 7 Understand the concept of quality of earnings.

Quality of Earnings Alternative Accounting Methods Pro Forma Income
Variations among companies in the application of GAAP may hamper comparability and reduce quality of earnings (FIFO vs. LIFO). Pro Forma Income Usually excludes items that are unusual or nonrecurring. Some companies have abused the flexibility that pro forma numbers allow to put their companies in a more favorable light. SO 7 Understand the concept of quality of earnings.

Quality of Earnings Alternative Accounting Methods
Some managers have felt pressure to continually increase earnings. Abuses include: Improper recognition of revenue (channel stuffing). Improper capitalization of operating expenses (WorldCom). Failure to report all liabilities (Enron). SO 7 Understand the concept of quality of earnings.

Quality of Earnings Price-Earnings Ratio
Reflects investors’ assessment of a company’s future earnings. P-E ratio will be higher if investors think that earnings will increase substantially in the future. P-E ratio will be lower when there is the belief that a company has poor-quality earnings. Illustration 13-19 SO 7 Understand the concept of quality of earnings.

Quality of Earnings Price-Earnings Ratio
Illustration 13-19 Illustration 13-20 Earnings per share and P-E ratios of various companies SO 7 Understand the concept of quality of earnings.

Quality of Earnings Illustration: Match each of the following terms with the phrase that it best matches. Comprehensive income Vertical analysis Quality of earnings Pro forma income Solvency ratio Extraordinary items Measures the ability of the company to survive over a long period of time. Usually excludes items that a company thinks are unusual or non-recurring. Includes all changes in stockholders’ equity during a period except those resulting from investments by stockholders and distributions to stockholders. Solvency Pro forma Comprehensive income SO 7 Understand the concept of quality of earnings.

Quality of Earnings Illustration: Match each of the following terms with the phrase that it best matches. Comprehensive income Vertical analysis Quality of earnings Pro forma income Solvency ratio Extraordinary items Indicates the level of full and transparent information provided to users of the financial statements. Describes events and transactions that are unusual in nature and infrequent in occurrence. Expresses each item within a financial statement as a percent of a base amount. Quality of earnings Extraordinary items Vertical analysis SO 7 Understand the concept of quality of earnings.

Comprehensive Ratio Analysis
appendix 13A Analyzing financial statements involves: Characteristics Comparison Bases Liquidity Profitability Solvency Intracompany Industry averages Intercompany The financial information in Illustrations 13A-1 through 13A-4 will be used to calculate Chicago’s 2009 ratios.

appendix 13A Illustration 13A-1

appendix 13A Illustration 13A-2 & 13A-4

appendix 13A Illustration 13A-3

appendix 13A Liquidity Ratios Measure the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash. Short-term creditors such as bankers and suppliers are particularly interested in assessing liquidity. Ratios include the current ratio, the current cash debt coverage ratio, the receivables turnover ratio, the average collection period, the inventory turnover ratio, and average days in inventory.

appendix 13A Current Ratio - Expresses the relationship of current assets to current liabilities. Calculate the current ratio for 2009 and 2008. Illustration 13A-5 .67 .60 What do the measures tell us? A current ratio of .67 means that for every dollar of current liabilities, the company has $0.67 of current assets.

appendix 13A Cash Debt Coverage Ratio - Because it uses cash provided by operating activities, it may provide a better representation of liquidity. Calculate the ratio for 2009 and 2008. Illustration 13A-6 .37 .39 Is the coverage adequate? Probably so. Chicago’s coverage is better than that of General Mills, and it approximates an accepted threshold of .40.

appendix 13A Receivables Turnover Ratio – Measures the number of times, on average, a company collects receivables during the period. Calculate the ratio for 2009 and 2008. Illustration 13A-7 11.9 12.0 How does Chicago’s turnover compare to General Mills’s? The turnover of 11.9 times is lower than the industry average of 14.0 times, and slightly lower than General Mills’s turnover of 12.8 times.

appendix 13A Average Collection Period – Converts the receivable turnover ratio into days. Calculate the collection period for 2009 and 2008. Illustration 13A-8 30.7 30.4 How effective is Chicago’s credit and collection policies? General rule - collection period should not greatly exceed the credit term period (i.e., the time allowed for payment).

appendix 13A Inventory Turnover Ratio - Measures the number of times average inventory was sold during the period. Calculate the ratio for Chicago for 2009 and 2008. Illustration 13A-9 7.5 7.9 How does Chicago’s turnover compare to General Mills’s? The ratio of 7.5 times is higher than the industry average of 6.9 times and better than General Mills’s 6.2 times.

appendix 13A Days in Inventory - Measures the average number of days inventory is held. Calculate the days for Chicago for 2009 and 2008. Illustration 13A-10 48.7 46.2 How does Chicago’s days compare to General Mills’s? An average selling time of 49 days is faster than the industry average and faster than that of General Mills.

appendix 13A Solvency Ratios Solvency ratios measure the ability of a company to survive over a long period of time. Debt-Paying Ability Debt to total assets ratio Times interest earned ratio Cash debt coverage ratio Free cash flow provides information about solvency and ability to pay additional dividends or invest.

appendix 13A Debt to Total Assets Ratio – Indicates the degree of financial leveraging. Provides some indication of the company’s ability to withstand losses. Calculate the ratio for 2009 and 2008. Illustration 13A-11 78% 81% Has Chicago’s solvency improved during the year? Yes, slightly. The ratio of 78% says that Chicago would have to liquidate 78% of its assets at their book value in order to pay off all of its debts.

appendix 13A Times Interest Earned Ratio - (also called interest coverage) indicates the company’s ability to meet interest payments as they come due. Calculate the ratio for Chicago for 2009 and 2008. Illustration 13A-12 5.8 5.8 Is Chicago better able to service its’ debt? Yes, the debt to total assets ratio decreased during 2009 and the times interest earned ratio held constant.

appendix 13A Cash Debt Coverage Ratio - Indicates a company’s ability to repay its liabilities from cash generated from operating activities without having to liquidate the assets used in its operations. Calculate the ratio for Chicago. Illustration 13A-13 .17 .17 One way of interpreting this ratio is to say that net cash generated from one year of operations would be sufficient to pay off 17% of Chicago’s total liabilities.

appendix 13A Free Cash Flow - Ability to pay dividends or expand operations. Calculate the ratio for Chicago. Illustration 13A-14 556 507 (in millions) Cash provided by operations was more than enough to allow Chicago to acquire additional productive assets and maintain dividend payments.

appendix 13A Profitability Ratios Measure the income or operating success of a company for a given period of time. Illustration 13A-15 Relationships among profitability measures

appendix 13A Return on Common Stockholders’ Equity Ratio - Shows how many dollars of net income the company earned for each dollar invested by the owners. Calculate the ratio for Chicago. Illustration 13A-16 48% 46% Chicago’s 2009 rate of return on common stockholders’ equity is unusually high at 48%, considering an industry average of 30% and General Mills’s return of 29%.

appendix 13A Return on Assets Ratio - Measures the overall profitability of assets in terms of the income earned on each dollar invested in assets. Calculate the ratio. Illustration 13A-17 10% 9.4% Note that Chicago’s rate of return on common stockholders’ equity (48%) is substantially higher than its rate of return on assets (10%). Chicago has made effective use of leverage.

appendix 13A Profit Margin Ratio - Or rate of return on sales, is a measure of the percentage of each dollar of sales that results in net income. Calculate the ratio for Chicago. Illustration 13A-18 9.4% 9.2% High-volume (high inventory turnover) businesses such as grocery stores and pharmacy chains generally have low profit margins.

appendix 13A Asset Turnover Ratio - Measures how efficiently a company uses its assets to generate sales. Calculate the ratio for Chicago. Illustration 13A-19 1.07 1.02 The average asset turnover for utility companies is .45, for example, while the grocery store industry has an average asset turnover of 3.49.

appendix 13A You can analyze the combined effects of profit margin and asset turnover on return on assets for Chicago as shown Illustration 13A-20

appendix 13A Gross Profit Rate - Indicates a company’s ability to maintain an adequate selling price above its cost of goods sold. Calculate the ratio for Chicago. Illustration 13A-21 44% 44% As an industry becomes more competitive, this ratio declines.

appendix 13A Earnings Per Share - A measure of the net income earned on each share of common stock. Calculate the ratio for Chicago. Illustration 13A-22 $2.63 $2.40

appendix 13A Price-Earnings (P-E) Ratio - Reflects investors’ assessments of a company’s future earnings. Calculate the ratio for Chicago. Illustration 13A-23 20.1 20.9 A higher P-E ratio suggests that the market is more optimistic about Chicago. It might also signal that its stock is overpriced.

appendix 13A Payout Ratio - Measures the percentage of earnings distributed in the form of cash dividends. Calculate the ratio for Chicago. Illustration 13A-24 43% 45% This ratio should be calculated over a longer period of time to evaluate any trends.

Key Points The tools of financial statement analysis covered in this chapter are universal and therefore no significant differences exist in the analysis methods used. The basic objectives of the income statement are the same under both GAAP and IFRS. Thus, both the IASB and the FASB are interested in distinguishing normal levels of income from irregular items in order to better predict a company’s future profitability. The basic accounting for discontinued operations is the same under IFRS and GAAP.

Key Points Under IFRS, there is no classification for extraordinary items. In other words, extraordinary item treatment is prohibited under IFRS. All revenue and expense items are considered ordinary in nature. The accounting for changes in accounting principles and changes in accounting estimates are the same for both GAAP and IFRS. The income statement under IFRS is referred to as a statement of comprehensive income. The statement of comprehensive income can be prepared under the one-statement approach or the two-statement approach.

Key Points GAAP also permits the one-statement or two-statement approach. In addition, GAAP permits a third alternative, which is to show the computation of comprehensive income in the statement of stockholders’ equity. The issues related to quality of earnings are the same under both GAAP and IFRS. It is hoped that by adopting a more principles-based approach, as found in IFRS, many of the earnings’ quality issues will disappear.

Looking into the Future
The FASB and the IASB are working on a project that would rework the structure of financial statements. Recently, the IASB decided to require a statement of comprehensive income, similar to what was required under GAAP. In addition, another part of this project addresses the issue of how to classify various items in the income statement. A main goal of this new approach is to provide information that better represents how businesses are run. In addition, the approach draws attention away from one number—net income.

The basic tools of financial analysis are the same under both GAAP and IFRS except that:
horizontal analysis cannot be done because the format of the statements is sometimes different. analysis is different because vertical analysis cannot be done under IFRS. the current ratio cannot be computed because current liabilities are often reported before current assets in IFRS statements of position. None of the above.

Under IFRS: the reporting of discontinued items is different than GAAP. the reporting of extraordinary items is prohibited. the reporting of changes in accounting principles is different than under GAAP. None of the above.

Presentation of comprehensive income must be reported under IFRS in:
the statement of stockholders’ equity. the income statement ending with net income. the notes to the financial statements. a statement of comprehensive income.

Copyright “Copyright © 2011 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.”

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